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Subprime loans: the easy money spigot hurt due diligence

Subprime loans are having their 10 minutes of fame. Hopefully, that is.

Treasury Secretary Henry Paulson's "it is largely contained" announcement was an expression of wishing for very short-lived problems in that market.

Such cheerleading seemed especially necessary in the wake of a report by the Mortgage Bankers Association. It revealed a record number of quarterly foreclosures on mortgages (1 in 185) in the 37 years since that particular statistic has been tracked. One in 50 subprime mortgages was affected, and more than 13 percent of subprime loans were delinquent.

But what exactly are subprime loans and what went wrong? The classification is usually used for loans to borrowers with poor credit records.

In a free-enterprise system, the additional risk can be paid for through higher interest payments than so-called prime borrowers would have.

Although some have criticized the inherent incongruity in giving loans to people who are more likely to default and then charging them much higher interest, such voluntary arrangements are prone to make both sides better off. The opportunity to own a home is extended to a larger number of people while higher payments indemnify lenders somewhat against the elevated risk.

The explanation of what went wrong is simple even though the process itself is intricate. It can be put into two words: easy money. A confluence of events, including low-target rates set by the Federal Reserve and billions of dollars in new foreign reserves (because of persistent and large U.S. trade deficit), led to a surge of funds in search of investment opportunities. Many originators of subprime loans resell those mortgages to banks. The banks, in a multitiered process called securitization, slice these mortgages into packages with various risk characteristics, which are used to secure and sell bonds. For years, this was a veritable money-making machine. Originators and banks received rich fees while investors enjoyed very high returns. The downside was controllable because of rising prices in the housing market. This seemingly unstoppable spigot of money did, however, lead to unsavory business practices. Due diligence by originators and the individual brokers they used went out the window. Borrowers were able to obtain back-loaded mortgages without proper paperwork. Investors were willing to pay more for the mortgage-backed bonds than a rational risk-analysis would have suggested. The party came to a screeching halt when the housing market slowed down.

The economy is now dealing with the hangover. Record foreclosures are pressuring the real estate market further. Several smaller subprime lenders have had to close down. Some industry leaders had to restate earnings or are believed to face bankruptcy proceedings.

Most economists agree - assuming the market for prime loans holds steady - that the repercussions of this episode will not considerably weaken the U.S. economy.

It is, however, likely that credit will be tighter for even qualified subprime borrowers. This is worrisome in view of the numerous positive economic and communal effects that first-time homeownership conveys.

Given this trend, it is imperative that regulatory plans afoot in Congress do not further cut off funding to suitable low-income borrowers.

Dr. Michael Reksulak teaches economics and public finance in Georgia Southern University's College of Business Administration. He may be reached by e-mail at mreksula@ georgiasouthern.edu.